Stop In Case You Drop

Recently, I answered a question from Pieter Lessing about stop-loss orders. If you don’t know what they are, or are interested in revivifying comic book characters, check it out. Today, for those of you just joining us (this is actually my 420th “comment” on the Ceres — now Ameritrade — web site), let me reprise the rest of Lessing on losses. He writes:

Could you comment on STOP LOSS ORDERS AS PART OF AN OVERALL INVESTMENT STRATEGY? I have stop loss orders on most of my equity positions (approximately 20% below the current trading price) for the following reasons:

a) To lock in a profit, once I have one. I finally decided that buying a stock at $18, see it zoom to $40, then down to $7 in less than a year is dumb, not to mention painful. To have sold at $32 ($40 minus 20%) would have been just fine. It would have worked in this case, because the climb up to $40 never had dips as big as 20% along the way.

b) Protect against catastrophe. I travel internationally, and am out of touch w/ quotes & brokers for weeks at a time. If the big one hits while I don’t have access to my account, I have a theoretical limit to my loss. (I realize that I may lose more than 20% if the dive is REAL fast, but since I’ve made quite a bit more than that in most of my positions, I’m willing to accept that.) If the Dow zips down to 2,000 in an hour, I figure we have bigger problems to face anyway. However, if it takes a few days to get down to 2,000, I would be in an all cash situation, buying like crazy!

c) Set the limit of loss when buying a new highly speculative stock. (Sure, it may triple after first going down 20%, but it can also keep on going down.) Preservation of capital.

PS: Just like any other investment strategy (or Vegas gambling system), the above does have its weaker points (tax implications, commissions, etc.)

Pieter goes on to say that he’s not dogmatic about that 20% number. He may set his stops looser, allowing for even more of a dip, if he thinks the stock is very volatile and/or if he has a really big profit in it.

So what do I think? I think, mainly, that for Pieter this is a good strategy. It gives him peace of mind. Indeed, for anyone lucky enough to have gotten into this market in the last few years and doubled or tripled his or her money, it’s something to consider. The benefits, as Pieter has listed them, are clear. (But for the record, the Dow can’t drop to 2000 in a day, for two reasons. First, as I’m sure Pieter knows, there are “circuit breakers” that kick in at various stages to keep the market from falling off a cliff. Second, at least two Dow components, Coke and GE, only go up.)

But the negatives of this strategy keep me personally from using stops very often.

If you’re speculating in stocks because they may go up, this is a strategy to consider. If you’re buying them to get a stake — perhaps at what you consider a bargain price — in a company you want to own, whose profits you want to share, and in whose growth you want to participate, then this is not such a good strategy. It means that you will frequently find yourself selling stocks you thought were worth owning at one price for no reason other than they are now 20% cheaper (if you set your stop at a 20% loss).

When a sale is triggered, you have that 20-plus percent loss (plus, because it’s not unlikely that, as the stock is dropping, your sell order will fetch a still lower price). You incur a brokerage commission (happily, this has become all but trivial). You eat the “spread” between bid and asked prices (not so trivial on some stocks). And, if it’s a stock in which you have a profit in a taxable account, you give up a chunk to Uncle Sam.

Granted, if you’re holding a stock at $150 a share for which you paid $28, it’s not too terrible a prospect. You may think of this as play money to begin with. (You know how magnanimous you get at Monopoly when you have hotels every place and there’s no way you won’t win? How when your cash is piling up and you land on someone else’s pathetic little property, with $23 rent, you flip them a hundred and tell them to keep the change? That’s what’s going on here.)

And then there’s the conundrum of just how tight to set your stops. The tighter you set them, the less you’ll lose on any given position — but the more you may lose in the long run, as you are whipsawed out of stocks that are basically headed up, but dip occasionally by enough to trigger the stop.

A final conundrum is whether to place a straight “stop” or a “stop limit” order. With a stop, when your stock trades at $25 (or wherever you set your stop), your broker will automatically enter a market order to sell your shares. In a thinly-traded stock dropping fast (in part because you are not the only guy who’s been setting stops), that could mean getting your order filled not at $25 or $24-3/4 but $16. Literally. It can happen.

To protect against this, you can enter a “stop limit” order — to sell if the stock trades at $25, but only if you can get at least $24, say.

That way, you know for sure the worst price you’ll get is $24, which is a big plus . . . except that it also may defeat the whole purpose of the stop in the first place. Because if this is the next Bre-X and you want out at any price, there you will likely sit with the stock at $2, wishing you had set no limit and gotten “just” $16.

There’s no free lunch.

On balance, and though it will vary tremendously from investor to investor, stops probably cost stock-market investors more than they save them. But that is simply the price you pay for peace of mind.

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Where stops do make lots of sense is in commodities speculation, where you can actually lose more than your entire stake, and where your reason for buying coffee futures wasn’t that you actually wanted to own a few tons of coffee, just that you thought the price might go up. Commodities speculation is an idiotic enterprise for lay investors like you or me, but downright suicidal without stops. (And I am so sick of all the innuendo and misinformation about Hillary Clinton’s commodities adventure, I’d like to stop your snickering right now. The full story is laid out in great detail in Jim Stewart’s Blood Sport, and it turns out that — other than handling the public relations aspects of the episode very badly — she did nothing wrong. I’ll bet not one American in 100 knows that.)

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Notes to newcomers:

Unlike this one, most of the “comments” you’ll find here are relatively short. (One was a single word.)

Many are on ridiculous topics like the nutritional value of ostrich meat or the top 10 ways to know you’re dating a consultant or the top 10 reasons not to buy mutual funds (even though I’m a strong believer in low-expense no-load mutual funds) or — especially — the top ten reasons to buy my new book.

I really do read and greatly appreciate your feedback, both pro and con. (Be sure to let me know if you would rather I not use your name if I quote you here.)

The archives don’t get go back more than a week because, while one or two may have the shelf life of a fruitcake, most are — at best — a croissant to accompany your morning coffee.